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Grantham on incredibly irrational Markets

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In his latest quarterly letter, GMO’s Jeremy Grantham offers some very interesting data on the disconnect between the stock market on one hand, and the economy and 'fair value' of the stock market on the other.

'This difference is massive - two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend,' Grantham writes in the letter, which is available on GMO's web site. 'The market's actual price - brought to us by the workings of wild and wooly individuals - is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!'

Grantham says the biggest reason for this disconnect is career risk for professional investors. Being wrong on your own can be career suicide, he says, so most of the pros 'go with the flow.' That way, even if they are wrong, they can say that they weren't alone. And that creates herding and momentum, which drive markets far out of whack with economic and corporate realities.

Grantham talks about how his firm has tried to battle that tendency, and offers some tips for how to go against the flow: 'You apparently can survive betting against bull market irrationality if you meet three conditions,' he says. 'First, you must allow a generous Ben Graham-like 'margin of safety' and wait for a real outlier before you make a big bet. Second, you must try to stay reasonably diversified. Third, you must never use leverage.'

(Read the full story in The Guru Investor)

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